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Active vs passive investment strategies

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Cape Town - The ongoing debate around passive versus active investment management has received a lot of attention in recent years thanks to the explosion of exchange traded funds that have become available to South African consumers.

Unfortunately for active managers, a lot of the facts that have emerged in this debate do not make for pleasant reading.

Depending on what unit trust survey you consult, and the time frame over which the analysis was conducted, only between 15% and 25% of active unit trust managers in South Africa manage to outperform the All-Share index over a five-, ten- and 20-year horizon. Put another way that implies that you have a 75% to 85% chance of underperforming the market over a five to 20-year timeframe when using actively managed investment solutions.

“Very few active managers consistently beat the index over time,” says Anne Cabot-Alletzhauser, Head of the Alexander Forbes Research Institute, a self-confessed fan of index tracker funds. “Whichever option you take you need to develop the right expectations so that you understand what the asset class or type of investment product you have can do for you.”

Taking the scepticism towards active investment management a step further, Cabot-Alletzhauser says a useful exercise to determine whether the result of an endeavour comes down to luck or skill is to ask the following questions:

-  Can you deliberately lose at the endeavour?
-  Does practice make perfect?
-  Do the results revert to the mean in the long-term?

Using roulette as an example of an activity whose results are purely determined by luck and comparing it to chess, an endeavour in which skill plays a big role, the above questions can then be applied to asset management.

You may think that you can deliberately lose at asset management but that is not necessarily the case. Sometimes a bull market can drag up the shares of even poorly managed companies. The general consensus is that asset management generally lies closer to the luck side of the continuum than pure skill.

However, some argue that this is only the case in the short term. Over the long-term, active managers are able to present some powerful evidence in their favour.

Active managers show their true worth in a bear market

Research by Orbis, Allan Gray’s offshore investment partner, suggests that active managers show their true worth in a bear market. Using information from the largest drawdowns that have occurred in Orbis’s Global Equity Fund since January 1990, the money manager found that it took an average of just nine months for the fund to recover from a quarterly loss, compared to 20 months for a passive investment in the FTSE World Index.

Similarly, it took Orbis’s Global Equity Fund 42 months to recover from its worst-ever drawdown in the last 25 years (a 50% decline) compared to 66 months for a passive investment in the FTSE World Index (which suffered a worst drawdown of 54%). For the second-worst drawdown over the period (29%) it took the Orbis Global Equity Fund just 15 months to recover compared to a massive 68 months for the FTSE World Index (which suffered a 45% slump in its second-worst drawdown).

The recovery period for the Orbis Global Equity Fund after its third-worst drawdown (a 22% decline) was 21 months compared to 39 months for the FTSE World Index (which plunged 25% in its third worst drawdown).

“As active managers we obviously think active managers can do a great job for investors,” says Richard Carter, Head of Product Development at Allan Gray. “That’s because we’re not only focused on giving you a return on your capital - we’re just as focused on returning your capital.”

Nevertheless, Carter says that the debate between active and passive management is somewhat academic. A far more important issue, he argues, is developing a clear understanding of what your active manager is trying to achieve for you and whether or not you agree with that philosophy.

Value-based investment strategy

This is where it’s worthwhile doing some research to find out whether your asset manager follows a deeply value-based investment strategy or whether they are more fundamental or perhaps quantitative in their decision making.

Value investors tend to favour assets that are trading below their intrinsic value whereas quant funds typically use complex computer-based algorithmic models to determine whether or not a share is worth buying.

Understanding your fund manager’s investment philosophy, and more importantly deciding if it is right for you, means you are much more likely to ride out short-term market volatility and remain invested for the long-term. That will help prevent the tendency of many investors to switch out of funds every time their portfolio experiences a minor downturn.

“If you’re going to try and switch out of a fund every time your portfolio takes a downturn then you’re going to be constantly disappointed. In that scenario it would actually be better if you didn't check up on your portfolio too often,” says Carter.

“Trying to switch in and switch out in an attempt to time the market is usually what ends up losing people money. Get the big decisions right and leave the fine tuning to your investment manager.”

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